Archive for December 24th, 2008

Stephen Cecchetti and Kermit L. Schoenholtz have written an excellent paper on ECB’s ten years and its performance in those ten years. I haven’t come across a free version of the paper, anyone who does do let me know. The paper is different as it is not a typical paper which looks at data and compares the performance with other central banks. Instead:

In this history of the first decade of ECB policy, we also discuss key challenges for the next decade. Beyond the ECB’s track record and an array of published critiques, our analysis relies on unique source material: extensive interviews with current and former ECB leaders and with other policymakers and scholars who viewed the evolution of the ECB from privileged vantage points. We share the assessment of our interviewees that the ECB has enjoyed many more successes than disappointments. These successes reflect both the ECB’s design and implementation.

The authors highlight there are 2 challenges for ECB going ahead:

Looking forward, we highlight the unique challenges posed by enlargement and, especially, by the euro area’s complex arrangements for guarding financial stability. In the latter case, the key issues are coordination in a crisis and harmonization of procedures. As several interviewees suggested, in the absence of a new organizational structure for securing financial stability, the current one will need to function as if it were a single entity.

Coordinating for financial stability is surely a challenge for ECB. There is a new paper by Sylvester Eijffinger where the author suggests that there is a need for European Financial Services Authority (EFSA):

European politicians will have to agree on a European federal supervisor, either a European Financial Services Authority (EFSA) or a European System of Financial Supervisors (ESFS). This European supervisor has to serve as an umbrella organisation for the national central banks and supervisors and should be responsible for the complete financial supervision in the European Union, mainly dealing with the cross-border effects of individual supervisor’s actions (see: my Briefing Paper of June 2007 and Schoenmaker and Oosterloo, 2007).

It should be independent from the ECB to guarantee monetary stability, but the two bodies must cooperate and inform each other. National supervisors remain to exist, as they have insights in local financial institutions and markets. For cross-border banking and finance, however, uniform EU-wide rules should be adhered to.

ECB is already thinking of setting a central counterparty for money markets and would be looking at financial stability in much details after crisis settles down. Expect a lot of papers and suggestions on this topic then- How should Euroarea manage financial stability?

Now coming back to Cecchetti paper, the authors point the communication challenge at ECB. The challenge of uniting so many countries with different cultures and language was always there and communication issues are a given with ECB.They ask Otmar Issing of the issues at hand:

Otmar Issing: “Translation was, of course, linguistically always very good, but the same words and phrases may seem different against the background of different historical experiences. For example, one colleague once said to me, ‘Otmar, we have a paragraph containing three times a reference to price stability. I think this is too much for this argument. In my country, if you say three times why you seek price stability, it weakens your argument.’ And my argument was, if in Germany it’s only two times, they say, ‘Oh, is the ECB less stability oriented than the Bundesbank?’

It must have been a task for sure and comapred to the tasks, the question over performance does not arise really. This remark keeps making me think whether behavioral economics could be used to understand inflation expectations better. So, far it is a pretty rational model assuming it to be formed in similar manner acroos nations. But then, these differences over how certain populations think of inflation and expectations are bound to be there.

These expectations arise as a result of central bank role and how central banks communicate. Bundesbank was pretty successful in managing inflation and German people would expect ECB to be the same. Where as the other economy Issing mentions, the record may not be as good and hence public might expect things to be wrong.

On similar lines, I am still amazed why Bank of Japan could not shape inflationary expectations despite much easing and a commitment to generate the same. BoJ is criticised for being slow and not taking right deicions at right time. But still they did try and change the policies. But were unsuccessful to generate inflation expectations which should be quite easy as per models. All it takes is print money. Why should Japanese public be so pessimistic after so many years as they should realise that it is in their favor to be optimistic.

What could be done to make research/policy help form inflation expectations better?

I had posted about a speechfrom Otmar Issing where he explaisn why ECB did not choose inflation targeting regime. There were 2 main reasons- lack of a Euroarea Economic Model and inflation targeting does not focus on role of money in determining inflation.

Before I come back to these questions, let me be precise on history. To be frank, at first in our communication we did not exactly speak of a “two pillar approach”. (In internal discussions we had already used the term “pillar”. We had initially identified three pillars, the third one being the quantitative definition of price stability.) The public use of this term goes back to the press conference of 13 October 1998 in which the president communicated the adoption of “A stability-oriented monetary policy strategy for the ESCB” by the Governing Council. dual pillars of the strategy the monetary element and the inflation forecast or real economy element. Will they carry approximately equal weights or will you decide the relative weighting between the two pillars on a case by case basis?” (By the way this is not only evidence for the intelligence of the journalist but also for the successful ommunication of the ECB right from the beginning.)

Then a journalist asked: “I have a question about your monetary policy strategy regarding the

Wim Duisenberg answered:”…it is not a coincidence that I have used the words that money will play a prominent role. So if you call it the two pillars, one pillar is thicker than the other is, or stronger than the other, but how much I couldn’t tell you.”

Then it was discussed within ECB and was made official! This is quite neat.

And then Issing mentions why the two pillar approach. Again the reasons are much the same as in the case of not choosing inflation targeting. The need to emphasise the role of money in inflation – Pillar 1 and the various economic factors for price stability- Pillar 2.